The Top 5 Most Common Financial Models

The Top 5 Most Common Financial Models

What is financial modelling?

A financial model involves building financial models from scratch or maintaining and updating the existing one as to construct a financial representation of the financial condition of a financial security or a company. It is used to calculate, estimate and forecast financial numbers.

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Some might ask – what kind of skills do you need in order to build an efficient financial model that produces accurate and dependable results?

Well, we have prepared a list of skills that you need to achieve that:

Equip yourself with accounting knowledge

This is the most fundamental part of building a financial model. Building a financial model requires using financial information given in a company’s financial report. You have to understand some of the basic accounting terms such as revenues, expenses, assets, liabilities, income statement, balance sheet, and cash flow statements.

Know how to interlink the financial statements

By just understanding the 3 financial statements alone is not enough, you need to know how to interlink all the 3 financial statements together. There must be a flow and inter-relationship between them, in order to allow us to see the complete picture of the financial situation of a company.

You can click here to learn how are the 3 Financial Statements linked. 

Excel Skills

This is one of the most essential skills that you need to have to build a financial model. You can’t use Word or PowerPoint to build a financial model, because it doesn’t have the proper function that is required to build them. You are one step ahead of the others, if you know how to use most of the main keyboard shortcuts – this will save you a lot of time and allow you to build your financial model as quickly as possible.

Forecast the Financials

Forecasting is both an art and a science. This part is important, since the whole purpose of building a financial model is to arrive at an understanding of the future scenario of any financial situation. It’s good to understand what are the reasonable assumptions that should be used while forecasting the financials. You should never pluck random financials out of thin air.

If you would like to understand more on how to forecast the financials, this is a very good book for reference – Investment Valuation by Aswath Damodaran.

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Now that you have an idea of what you need to prepare to build financial models, let us introduce you the top 5 most common financial models of all time!

1. The 3 Statement Model

The 3 Statements Model links all 3 financial statements – income statement, balance sheet and cash flow statement into one dynamically connected financial model. This is the most basic model that one should understand before moving on to the more advanced financial models such as DCF, M&A, LBO and et cetera.

There are several steps required to build a 3 statement model, including:

  1. Input the historical financial information into Excel
  2. Determine the assumptions that will drive the forecast
  3. Forecast the income statement
  4. Forecast capital assets
  5. Forecast financing activity
  6. Forecast the balance sheet
  7. Complete the cash flow statement
  8. Discounted Cash Flow (DCF) Model

You can click here find out more about 3 statement model.

2. Comparable Company Analysis Model

Comparable company analysis model also known as comp analysis is used to determine a ballpark estimate of value for a company’s value or a stock price. It involves looking for other companies that are similar in terms of size, operations in the same industry or region.

This model allows you to compare a company to its peer group/competitors on a relative basis. The information obtained can be used to calculate other ratios for comparison with its peer group.

3. Discounted Cash Flow Model (DCF)

This model is the most widely used method of valuation in the finance industry. It uses the concept of time value of money to determine how far out into the future you should project cash flow. The purpose of this model is to identify whether a company’s stock is undervalued or overvalued. This could be a useful decision making factor for investors who would like to make any investments in any investment scenarios. This is usually used in equity research and other areas of the capital markets.

Here are the steps to build a DCF model:

  1. Project unlevered Future Cash Flows (UFCFs)
  2. Choose a discount rate
  3. Calculate the Terminal Value (TV)
  4. Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value
  5. Calculate the equity value by subtracting net debt from EV
  6. Review the results

You can click here to learn more about building a DCF model.

4. Mergers and Acquisition Model (M&A)

The purpose of M&A model is to assess the impact of a merger or an acquisition on the expected future earnings per share (EPS) of the newly formed company and how it compares with the existing EPS.

The transaction is said to be “accretive” if the EPS increases altogether, and transaction is said to be “dilutive” if the EPS decreases compared to the existing EPS. This model is commonly used by investment banks or corporate financing companies.

Here are the steps to build an M&A model: Valuing Target & Acquirer as standalone firms

  1. Valuing Target & Acquirer with synergies
  2. Working out an Initial offer for the target firm
  3. Determining combined firms ability to finance transaction
  4. Adjust cash/debt according to the ability to finance the transaction
  5. Calculating EPS by combining Net income and figuring out an accretive/dilutive situation

You can click here to have a quick view on how to model this.

5. Leveraged Buyout Model

Leveraged buyout is the acquisition of another company using mainly debt to finance the transaction. Debts will be paid off using the cash flows from the assets and operations of the acquired company. This is usually carried out by private equity firms.

Here are the steps to build an LBO model:

  1. Calculation of purchase price based on forward trading multiple on EBITDA
  2. Weightage of debt and equity funding for acquisition
  3. Building projected income statement and calculate EBITDA
  4. Calculation of cumulative FCF during the total tenure of LBO
  5. Calculating Ending exit values and Returns through IRR.

You can click here to learn more about building an LBO model.

We hope this brief introduction of financial modelling has been helpful. You can learn more about financial modelling from the links we provided in this article or you could visit our Invest Academy page for more by clicking on the view now button!

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